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529 E-ditorials

02-2: The State of Your State
Joe Hurley
Tuesday, March 12th 2002

By now, most people reading this E-ditorial are fully aware that qualified withdrawals from a 529 are excluded from federal gross income beginning this year. I think you would agree that this makes for a rather attractive tax break, at least for withdrawals before the "sunset" year of 2011.

Now the question is: What about state income taxes? Can you (or your beneficiary) take the same exclusion on your state income tax returns? If your family resides in a state with a fairly healthy income tax like New York, where I live, you will be interested in knowing the answer to this question. If you reside in a state without any income tax (i.e. those of you in AK, FL, NV, SD, TX, WA, and WY), then the issue is essentially moot and you can go on to other business without bothering with this E-ditorial.

To be honest with you, I think the importance of state income exclusion can be oversold even in the high-tax states. The benefit is generally much less valuable than an upfront deduction for your contributions (which 23 states now offer). Let's assume there is no exclusion available in your state. In most cases, withdrawals from a 529 plan that are used to pay for qualified college costs will be reported to your beneficiary (the student). Students tend to be in very low tax brackets, especially for state income taxes. Further, consider that the tax payment will be far off in the future, provided that your beneficiary has a few years before college, and so the tax cost can be heavily discounted. Even then, the payment of state income taxes may create an additional deduction against federal income tax for those who itemize.

But you still want to know the treatment in your state, don't you? Here is what we have concluded so far:

Plenty of states specifically exclude income on qualified withdrawals that come out of their own state 529 plans. Check this list to see if your state is one of these: AL, AZ, AR, CO, CT, GA, IL, IN, IA, KY, LA, ME, MD, MI (for the savings plan only), MS, MO, MT, NE, NH, NJ, NM, NY, NC, OH, OR, PA, RI, SC, TN, UT, VT, VA, and WI.

But what if you reside in one of those states and do not want to use your home-state 529 plan? Can you exclude qualified withdrawals from other states' 529 plans? The answer is a decided "YES" if you live in AZ, CO, and NJ. The laws in those states specifically exclude qualified withdrawals from any state's 529 plan. None of the other states ever extended their tax largesse to withdrawals from out-of-state plans, UNTIL the federal exclusion came along this year. If your state "conforms" to the federal definition of gross income, any withdrawal that is excluded for federal purposes will now be excluded for state purposes as well, no matter which 529 plan you are using.

From the list above, we can try to pick out those states that now appear to exclude all qualified withdrawals as a result of their conformity to federal tax law. These are CT, IL, LA, MD, MI, MO, MT, NE, NM, NY, OH, OR, RI, UT, VT, and VA. If you live in one of those states you should now be happier, but perhaps not as happy as those in AZ, CO, and NJ. The sunset of the federal tax law changes at the end of 2010 means that your state exemption for qualified withdrawals from out-of-state 529 plans may disappear in 2011.

(Of course, if you find yourself in position to take withdrawals from an out-of-state 529 plan in a year when only the withdrawals from your in-state 529 plan are excluded, you might consider a rollover of funds to the in-state plan before taking withdrawals. We'll leave further discussion of that possible escape hatch to another day.)

A few of the states that currently tax withdrawals from out-of-state 529 plans, but not from their own, are working on conforming legislation, but had not approved anything at the time this article was written. These states are GA, IN, IA, KY, and SC. There does not seem to be any conformity legislation yet in ME, NC and WI, but we wouldn't be surprised to see it come along in those states. We don't hold out much hope for AL, AR, MS, NH, TN or PA. The tax laws in those states are not closely tied to the federal definition of gross income in the first place.

Didn't find your state in any of the above discussion? That means your state never had a specific provision excluding qualified withdrawals from any 529 plan, even from its own. If you reside in DE, KS, MI (for the prepaid plan only), MN, ND and OK, you'll be happy to know that you now gain tax-free treatment, thanks to your state's conformity to federal tax law. If you reside in CA, HI, ID, MA, and WV you will have to hope for conformity legislation to pass. (If that doesn't happen, your beneficiary will pay state income tax even when you use your home state 529 plan ouch.)

I know this discussion is a little confusing, but it's information that people have been asking about. It is not intended to serve as tax advice, so please rely on your own tax adviser for information about your state taxes, not on this E-ditorial.
Key: AL(Alabama), AK(Alaska), AZ(Arizona), AR(Arkansas), CA(California), CO(Colorado), CT(Connecticut), DE(Delaware), FL(Florida), GA(Georgia), HI(Hawaii), ID(Idaho), IL(Illinois), IN(Indiana), IA(Iowa), KS(Kansas), KY(Kentucky), LA(Louisiana), ME(Maine), MD(Maryland), MA(Massachusetts), MI(Michigan), MN(Minnesota), MS(Mississippi), MO(Missouri), MT(Montana), NE(Nebraska), NV(Nevada), NH(New Hampshire), NJ(New Jersey), NM(New Mexico), NY(New York), NC(North Carolina), ND(North Dakota), OH(Ohio), OK(Oklahoma), OR(Oregon), PA(Pennsylvania), RI(Rhode Island), SC(South Carolina), SD(South Dakota), TN(Tennessee), TX(Texas), UT(Utah), VT(Vermont), VA(Virginia), WA(Washington), WV(West Virginia), WI(Wisconsin), WY(Wyoming).

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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